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Sustained weakness or momentary blip?

OCT. 11, 2018
  • Equity market volatility spiked in recent weeks, culminating with a 3.3% decline for the S&P 500 Index on Wednesday. So far in the seasonally-strong month of October, the S&P is -4.4%, the Russell 2000 is -7% and the NASDAQ is -8%. The VIX was below 12 five trading days ago and nearly doubled to 23 by Wednesday.
  • The incredible stability of markets in 2017 may have given investors a false sense of security. The fundamental strength of that year resulted in historically low volatility and market pullbacks. There were only four sessions that saw 1% declines for the year and no declines of 2%, while we have already 17 and 8, respectively, this year.
  • Notable in the weakness in equities was the lack of a flight-to-quality. Generally, when we see sharp declines in equities, investors flock to bonds. That has not been the case in this period, with many bond ETFs experiencing record outflows as rates rise. The correlation between stocks and bonds is at the lowest level since 2014 and the third-lowest since 2000. Other risk assets declined, including global stocks and oil prices.
  • Technology shares fell by 4% on Wednesday, led by the “FANG” (Facebook, Amazon, Netflix and Google) names. We are seeing a continued transition from the momentum-oriented technology names to the more stable growth companies. Since 2015, the FANG complex has returned nearly 9x the overall S&P, though have on average lost 22% since the recent high, while the S&P has lost only 5% and the technology sector fell 7%.

Market Concerns: There was no clear reason for the sharp decline, though there are several rational explanations:

  • Interest Rates: We have seen a sharp increase in interest rates in recent weeks, breaking a technical trading range between 2.73% and 3.10% that had existed since February. At 3.23%, the 10-year Treasury yield is at the highest level since 2011. Better-than-expected economic data has reset expectations for inflation, though PPI & CPI remain benign. Expectations for rate hikes have moved higher following more hawkish Fed commentary, with a 53% chance of three or more hikes over the next 12 months, up from 41% a month ago.
  • Earnings: As we enter earnings season, expectations are for a strong result, but uncertainty exists over forward guidance given possible headwinds from rates, commodity prices, the strong dollar and the slowdown in China. Earnings are likely to remain healthy due to the strength of the domestic economy, but the U.S. is again doing the “heavy lifting” for the global economy, and it will be critical to listen to earnings calls to gauge the plusses and minuses from managements.
  • Midterms: Volatility is historically elevated in the months preceding a midterm election, with the average daily move 45% higher than a normal month in the month before the election. As the election approaches and uncertainty fades, volatility tends to decline, with November down 12% and December down 27%. Performance is generally strong in the fourth quarter of a midterm year.


  • We have seen a spike in volatility in a sluggish period for equity returns, but the move is not unusual, particularly given the uncertainties. This is similar to the February and March period where growing uncertainties distracted investors from the strong fundamental backdrop.
  • For perspective, the decline is only 5% for the S&P 500 Index since the market high in September, which has delivered a positive return of 6% for the year and 11% for the past 12 months.
  • The economy and earnings environment should support continued positive returns. Consumer and corporate confidence remains near record highs, and there is recent evidence that consumer spending and capital goods orders are accelerating. With consumer, government and corporate spending all accelerating, the three legs of the economic stool are all supportive. Earnings growth for the S&P 500 is expected to exceed 20% this year, with double-digit growth forecasted for 2019 and 2020. While headwinds exist, accelerating capital spending and share repurchase activity could provide upside.


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